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This article will explain why Wall Street is failing to understand Advanced Micro Devices' return to profitability, despite their love of low gross margin growth businesses, which are based upon superior technology.

Are Wall Street shorts overly influencing the sell side analysts?

Wall Street puts astronomical PE multiples on Amazon (NASDAQ:AMZN) and Tesla (NASDAQ:TSLA), but maintains a negative attitude towards AMD, with a massive short interest position of over 100 million shares. But, there was a time period that Wall Street had massive short interest bets against both Amazon and Tesla. We all know how the shorts faired in those bets.

Most shorts are Hedge Funds that generate huge trading commissions for Wall Street's sell side firms. It is only natural that these firms want to support the positions of their most profitable clients. While mutual funds control vast assets, their trading and commission generation are under close scrutiny, while hedge funds are not.

Wall Street analysts are letting their emotions from the past affect their understanding of the future

In talking to many of the Wall Street sell side analysts, I found they were letting their emotions about the past performance of AMD affect their judgments about the future. Many Wall Street analysts had forecast that AMD would report net losses for the third quarter going into the 2nd quarter conference call. So, it made zero sense that these same analysts downgraded AMD after learning the company was forecasting profitability for Q3. These analysts used the excuse that AMD's gross margins would be down a few percent in Q3 over Q2, instead of focusing on what really matters, the actual bottom line.

AMD new management is focused on long term sustainable profitability

A little over 2 years ago AMD brought in a new CEO, and he has been successful in attracting key talent away from the most successful technology companies, including Apple (NASDAQ:AAPL), Qualcomm (NASDAQ:QCOM), Cisco (NASDAQ:CSCO), etc. As noted in this Seeking Alpha article, AMD's new management has a long term plan for sustained bottom line profitability and top line growth, that is built around semi- custom and embedded products.

It is simply crazy for Wall Street to favor higher gross margins, when the cost of maintaining those sales produces losses or no profits. AMD's new semi-custom design wins are for numerous years, which will eliminate most of the requirement for future marketing expenses to retain those customers. Furthermore, the long cycle wins means that there is little chance that AMD will get stuck with obsolete inventory.

AMD's new growth businesses in the semi-custom/embedded space means that most all of the future gross margins drops directly to the bottom line

AMD has spent the last 2 years or so working on collaborative semi-custom/embedded deals, which can only be announced when the customer is ready. Most of the costs have already been spent on research and development of these semi-custom/embedded products. Therefore, when revenues and gross margins increase as these deals come to fruition, there is no commensurate increase in expenses. Therefore, most of the gross margin drops directly to the bottom line. Wall Street analyst and their short selling overlords made a huge deal about the approximate initial 25% gross margins attached to the game box area. But, none of them were smart enough to realize that 90% of that gross margin drops directly to the bottom line. It is beyond my imagination how these analysts can complain about net margins that exceed 20%.

Wall Street analysts are obsessing over the PC area, while AMD has more than offsetting growth in other areas

AMD is forecasting a 22% growth in revenues for Q3, yet Wall Street analysts are almost exclusively focused on the stagnant PC area. It does not matter that AMD's PC business will be flattish for the foreseeable future, because they have tremendous growth already in the pipeline from semi-custom/embedded products. Amazon's original business, selling books online, is not really growing much anymore, yet Wall Street analysts do not seem to care. While Wall Street analysts focus on anything positive about Amazon, they appear to focus mainly on whatever negatives they can find about AMD.

The catalysts for stock price appreciation will come from the Oct. 17 conference call

I expect a rally similar to what happened to Tesla's stock price early this year, just after they reported better than expected profits, and forecast for more of the same. Industry reports from AMD's semi-custom customers Sony and Microsoft, show that demand for their game boxes is extremely robust. It is my understanding that AMD issued very conservative Q3 forecasts for most parts of their business, especially for their newest products.

Wall Street continues to miss the huge trend in computing towards greater demand for graphics, as explained in this Seeking Alpha article. When Wall Street finally understands that AMD is better positioned for growth than practically any other major semiconductor company, its stock price will take on a life of its own, similar to the past explosions seen in AMD's stock price.

Building a model based upon the net additional game box business

AMD forecast a 22% rise in sales for Q3 over Q2, which works out to about a $250 million increase. The increase in sales was based almost entirely upon game box APU sales to Sony (NYSE:SNE) and Microsoft (NASDAQ:MSFT), which most industry (not Wall St.) analysts are estimating at approximately $80/each on average.

This works out to only 3 million chips per quarter, while Sony alone recently estimated 5 million boxes being sold from the November 15 launch to the end of March. Sony appears to be supply constrained, which is why sales will not start in Japan until February 22, 2014.

I believe there is evidence that demand will be stronger than expected for Microsoft's X-box One, because of its additional content deals and applications (fantasy football/TV, etc.) beyond hard core gaming.

On Oct. 2 IDC predicted : "the number of game console bundles shipped worldwide in 2013 will be marginally higher than the 2012 total of approximately 33 million bundles…"

"The number of online console gamers around the globe is on pace to exceed 165 million by 2017," said Lewis Ward, Research Manager, Gaming at IDC. "As a result, the opportunity to sell these gamers digital assets through Wii U, Xbox One, and PS4 online storefronts will grow substantially in the next several years." Ward adds that the Chinese government's recent decision to lift the ban on consoles should lead to millions of additional hardware bundle sales for the likes of Nintendo, Microsoft, and Sony within three years."

It only makes sense that sales will be higher in 2014 than in 2013, when the initial supply constraints are worked thru, and the new game boxes can be sold in all territories, including sales to China's 1.4 billion people.

While AMD is currently receiving royalties from X-box 360 sales, they are not earning anything from the Sony PS3. Therefore, sales of the Sony's PS4 will produce incremental sales and profits to AMD.

While Sony's PS 4 is currently expected to outsell the X-box One, X-box total sales (including the heavily discounted X-box 360) should be up dramatically in 2014, over the supply constrained 2013 launch.

I think a reasonable estimate of total game box sales for Sony, Microsoft, and Nintendo is approximately 34 million in 2013, and 40 million in 2014, the first full year the new game boxes are available without supply constraints. China is the wild card, which could drive game box sales thru the roof over the next few years.

Sony's PS4 is estimated to sell about half of all game boxes sold in 2014, which works out to about 20 million units. 20 million units times $80 per APU= $1.6 billion in gross revenues to AMD.

$1.6 billion times 25% gross margin= $400 million gross profit

Since 90% of the gross profit fall directly to AMD's bottom line, the net profit addition to AMD's bottom line in 2014 from the addition of Sony's PS4 game box business will be at least $360 million.

Most industry analysts expect X-box sales in 2014 to be well above the current X-box 360 run rates, which means AMD's total profits from sales and royalties to Microsoft, will be up dramatically in 2014.

Therefore, I am adding in a very conservative $40 million of additional net profit from sales to Microsoft in 2014.

Bottom line, the game box business will provide AMD with an additional $400 of net profit in 2014.

AMD just finished their cost reduction program in Q3, which I estimate brought them to a breakeven point, before the addition of the new game box revenues. I base this estimate upon management's plan to pare the existing PC business costs, such that the company at least breaks on those units, based upon current forecasts.

Summation of the above business model for 2014

In 2014, AMD will be selling chips into all 3 major game boxes, which will result in approximately $2.5 billion of additional revenue over 2013. AMD will generate approximately $5 billion of total revenues in 2013 (at least $600 million from the game box business), and approximately $7.5 billion of revenue in 2014.

While most of the royalties that AMD receives from sales of the X-box 360 will be greatly diminished in 2014, the overall increase in sales of the X-box One will result in a net minimum increase in profits to AMD of about $40 million.

The $1.6 billion in APU sales to Sony for the PS4 will produce net profits to AMD of about $360 million in 2014.

Total net profits from AMD's game box business will increase by about $400 million in 2014.

Because AMD completed their cost reduction program in Q3 2013, all of the additional $400 of net profits will become earnings per share in 2014.

Using the 752 million fully diluted share count listed in AMD's Q2 10Q, means that AMD will generate 53 cents in earning per share for 2014, from the additional game box business alone. AMD has many $billions of tax loss carry forwards, which means there will be no US federal taxes paid for a number of years to come.

Additional sales and earnings growth prospects for 2014

Besides the game box business, AMD has excellent prospects to increase sales and profits in the server area.

This Seeking Alpha article outlines the significance of AMD's recently announced server deal with Verizon, one of the world's largest network operators.

This Seeking Alpha article touches upon why cloud servers will increasingly require more GPU power, which means that AMD will be in a much stronger position than Intel (NASDAQ:INTC), for next generation server chips.

Only Intel and AMD have the vast server chip experience and IP to effectively compete in the $12 billion a year server chip market. Currently Intel has a 95% market share, and AMD has the rest. Bottom line, it is not hard for me to imagine AMD taking back at least the 25% of this very profitable market, that they held in early 2006.

Long term potential downside in AMD shares

While AMD's PC business is relatively stagnant, I have yet to understand how any business person can replace all the required functionality of a PC, with a non PC tablet. In other words, while the PC market may continue to slowly shrink because many consumers do not need the full functionality offered by a PC, AMD's low cost PC chip business will remain relatively stable over the next few years.

Since most investors are very negative about the PC chip business, it is hard for me to imagine how reality will be worse than the current expectations.

Therefore, I do not see significant downside in AMD's share beyond the recent short selling induced low of about $3.3/share. With the shares currently trading at about $3.75/share, the downside does not appear greater than about 12%.

Long term potential upside in AMD shares

Based upon a 50% increase in AMD's revenues in 2014 over 2013, with earnings of at least 50 cents per share, I believe that AMD deserves at the very least a market multiple PE of 15 times earnings, equaling a stock price of $7.50 per share.

If AMD's cloud server chip business starts to get real traction with introduction of 64bit ARM products by the middle of 2014, Wall Street could get excited and assign a large premium multiple, such as they done with other cloud investment vehicles.

Additionally, I believe that AMD APUs will continue to dominate the living room console box market, which will grow to be much bigger than the current expectations for hardcore gamers only.

The upside in AMD's shares is at least 100% greater than the current share price, and could be many fold greater, if reality is closer to my optimistic outlook.

Conclusion

The massive short position in AMD (113.97 million shares) is proof positive that Wall Street has a very negative view of AMD's prospects. Most large turning points in stock prices, whether from the top or the bottom, occur when Wall Street expectations are highly imbalanced. Therefore, any news from AMD that is better than expectations can easily cause a buying stampede, which will swamp short sellers. Meanwhile, with such low expectations for AMD, despite the turnaround in the fundamentals, it is hard to see what unexpected bad news will send the shares down dramatically.

Bottom line, AMD has much greater upside than downside, based upon my analysis. If the shorts realize they are wrong, 113 million shares is an enormous amount of shares that must be bought to cover that position. I believe that both short term and long term investors should be positioning themselves for a huge rally in AMD shares, which will start during the 3rd quarter earnings conference call on Oct. 17th.

Disclosure: I am long AMD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Advanced Micro Devices: Why Shorts Are Facing Imminent Destruction